Are you confident in accurately reporting cryptocurrency earnings on your tax returns?

Towards Sovereignty: Crypto Self-Custody

Chandan Lodha

November 23, 2022  ·  6 min read

Towards Sovereignty: Crypto Self-Custody

Over the course of 2022, crypto users who keep their holdings on centralized exchanges have faced a number of wake-up calls. From temporarily halted withdrawals to more serious collapses in the case of BlockFi, Celsius, Voyager, and FTX, customers of these platforms have found that, ultimately, they do not control the assets displayed in their accounts.

Following the early November collapse of FTX, crypto holders have been rapidly shifting their funds off exchanges to self-custodied wallets. These transfers represent some of the largest outflows from exchanges in the history of crypto, demonstrating waning confidence in some centralized platforms.

A Wake-up call

Some crypto investors have demonstrated confusion around their ability to access funds held on exchanges and where they are truly located:

To answer Dave’s question, FTX may have held Bitcoin “for him,” but they did not apply best practices such as 1:1 asset backing, providing proof of reserves, and separating corporate assets from customer funds. It’s unclear what happened to FTX Global’s holdings, but now that they have entered bankruptcy proceedings, we will learn more over the next year.

Why Sovereignty matters

A major benefit of cryptocurrencies over other asset classes is that they do not require market participants to trust centralized parties, like a bank or government, for the system to operate.

The value of crypto is partly derived from the ability to self-custody assets yourself. This is completely unique to cryptocurrency in the digital world — no other digital asset can be self-custodied. As we say in the crypto world:

🔑 Not your keys, not your coins.

The phrase “not your keys, not your coins” is a mantra used by the crypto community to convey that you can only really be sure that you own the crypto coins if you control the private keys.

On the other hand, a world where all cryptocurrencies are centralized on a single exchange is one where assets could be at risk if they are in the hands of a bad actor.

The problem is that self-custody can be intimidating today and introduces specific challenges in terms of compliance, tracking, trust, and usability.

Therein lies our opportunity - and CoinTracker’s core mission:

💡 To enable everyone in the world to use crypto with peace of mind.

We call users who embrace self-custody “sovereign” users. Without the growth of sovereign users, cryptocurrency could easily be replaced by a centralized asset run by a company, bank, government, or organization.

A primer on self-custody

So you’ve decided to remove your funds from exchanges to a wallet of your own. Here are some key lessons and distinctions to understand.

Private keys

The most important sovereignty concept to understand is control over your private keys.

Private keys are similar to passwords and are used are to sign transactions and prove ownership of an address on a blockchain. Without the private key to the address where funds are currently located, crypto assets cannot be spent or transferred. Anyone who lacks the address’ private key cannot access the funds, including exchanges and government authorities.

Private key cryptography is a very secure form of encryption that takes the form of an infinite string or series of characters (in base ten notation), so long it would require millennia for one person to try every possible combination until they find your signature. For simplicity’s sake, private keys are usually represented by a shorter string of alphanumeric values.

The confidentiality of private keys is contrasted with public keys, which are analogous to a home address. For most blockchains, anyone can see the public address and how it transacts. Public keys are derived from private keys in complicated algorithms, but they do not grant control over the assets. A private key can determine its corresponding public key, but knowing a public key cannot tell you that address’ private key. Someone may be able to find your home address in the phone book, but they can’t get inside without your key. CoinTracker can track public key addresses in your portfolio, but will never ask for your private keys.

Hot wallets

A hot wallet is a type of cryptocurrency wallet that is connected to the internet. Hot wallets are convenient because they allow users to quickly and easily access their coins and tokens.

Hot wallets typically store the user's private keys in an online environment. This means that hot wallets are also more vulnerable to hacks and security breaches than cold wallets, which are not connected to the internet.

CoinTracker integrates with all hot wallets. Some of our most recognizable partners include Brave, Coinbase Wallet, Exodus, Phantom, and Trust.

We’ve joined forces with Coinbase Wallet to provide users with a simple and accurate crypto tax calculating experience. Coinbase Wallet users can choose to easily import crypto transactions into Cointracker with just a few clicks. Learn more here.

Cold storage

In contrast to hot wallets, cold wallets do not keep your private keys online. Cold storage means the keys are unconnected to the internet except for the brief moments a user connects them to a computer to complete a transaction. This method of securing crypto assets comes in a few different forms.

Paper wallets

A paper wallet is a type of cryptocurrency wallet that stores the user's private keys on a piece of paper. Paper wallets are as secure as you keep the object they’re written on, but they can be difficult to set up and use. Once you print your keys, they are generally removed from your digital wallet and the network. You’ll need to type them back in to create a transaction. Your keys cannot be hacked unless someone physically takes the paper on which you’ve stored them. However, if you lose your piece of paper, you’ve just lost access to your crypto.

The ease of losing paper wallets makes their use cumbersome. With advances in hardware wallets, many of the security guarantees of paper wallets have been outdated. It's safe to say that paper wallets are no longer considered one of the best ways to secure your private keys.

Hardware wallets

A hardware wallet is a type of cryptocurrency wallet that stores the user's private keys on a physical device. Hardware wallets are secure and convenient, but they can be expensive.

Private keys are stored offline in a protected area of the device and thus cannot be extracted over the internet by a virus or hacker. In contrast to a paper wallet, a hardware wallet is less vulnerable to damage and requires users to press a button on the device to confirm a withdrawal. You are still responsible for securing and not losing your hardware device.

If you choose to transact day-to-day using a hot wallet, we still recommend that you keep the majority of your holdings in a cold wallet.

Once you’ve moved off exchanges

Can tax authorities track self-custodied crypto?

Yes. Tax authorities use a variety of techniques to track cryptocurrency transactions and enforce tax compliance, and their capabilities are improving. They have at their disposal data analytics tools such as Chainanalysis and Palantir, which can tie crypto users’ identities from regulated cryptocurrency exchanges to their self-custodied wallets and transactions (including multiple layers removed from the exchange). It is important to stay tax compliant even as a sovereign user.

Are transfers to self-custody taxable?

Transfers are not considered taxable events (outside of India).

You likely spent a small portion of crypto as fees to transfer the assets off the exchange. These fees will be added to your cost basis of the transferred asset. The increased cost basis will likely lower your capital gains tax if you were to subsequently sell some or all of the asset, so it’s important to have good record keeping of all transactions.

CoinTracker can detect transfers between a connected exchange account and a public wallet address, and has a “transfer tagging” feature where you can label a transaction as a transfer between two wallets you control. This allows for seamless portfolio tracking, seeing how much you’ve gained or lost in your investments over your entire crypto journey.

How much crypto do you keep on exchanges?

Under the Portfolio Insights tab of the Performance page, CoinTracker tells you exactly how much of your crypto portfolio is currently located on centralized exchanges.

Image of funds held on exchanges

As a result, you are now better equipped to actively decide how much of your crypto assets you want to leave on a centralized exchange, if any! Remember: not your keys, not your coins.

Related Posts